If we improve our understanding of assets, we can do a better job of forecasting their returns and managing risks. We can also build better portfolios that deliver more consistent performance. A critical first step toward this goal is to focus on the underlying systematic risks with each asset and how those risks drive returns. Called a risk premium approach, this process focuses on risks as drivers of returns rather than sources of volatility. In this context, the key systematic risks are economic growth risk, interest rate risk and inflation risk.
A risk premia approach helps plan sponsors recognize the fact that people drive markets – that the human characteristics of investors also contribute to asset returns. Some of these human drivers simply introduce noise into asset prices, while others reflect exploitable behavioral biases that create opportunities such as carry strategies, loss aversion and the persistent avoidance of boring stocks that contribute to the low-volatility anomaly.
Ultimately, it isn’t the risks in the individual assets that matter as much as how those risks come together in a portfolio and the diversified way in which one gains exposure to each key risk and behavioral opportunity. One can target any desired normal mix of these return drivers, but deviations from this allocation should reflect the fact that the rewards offered for bearing each risk, and the opportunities created by behavioral biases, wax and wane with such factors as the business cycle and investor sentiment. Consequently, it’s important to dynamically manage the exposures in the portfolio to avoid one of the biggest risks of all: buying into exposure that is extremely overpriced or failing to buy exposures that are extremely attractively priced.
In summary, better portfolios come from focusing on the underlying drivers of asset returns, taking full advantage of opportunities created by investor biases and dynamically managing the exposures to these to reflect the changing risk/return opportunities and hazards they present.
Kevin Kneafsey is senior advisor, Schroders.